Rebalancing in the Baltics - A Preliminary Assessment

By Claus Vistesen: Copenhagen

"In my view … it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s." Bernanke (2009)

Executive Summary

• Compared with the average quarterly value of GDP in 2007-08, the first two quarters of 2009 are down in nominal terms to the tune of 15.9%, 15.4% and 10.5% in Lithuania, Estonia, and Latvia respectively.
  

• The average quarterly current account deficit of the Baltics from Q3 2008 to Q2 2009 was mill 500 Euros. This amount to just 18% of the average quarterly current account deficit two years prior to the crisis. Consequently, the Baltics have delevered to the tune of 80% over the course of less than 1 year.

• In the two first quarters of 2009 (relative to Q1-2006 to Q4-2008), imports have contracted 16%, 33% and 11.5% more than exports in Lithuania, Latvia and Estonia respectively.

• In Euro terms, the Baltics have lost external financing to the tune of bn 1.87 Euros in the first half of 2009 compared to the peak of the boom which amounts to 12.6% of the entire region's GDP in the same period.

The quote above from Fed chairman Bernanke is ripped from the introduction of a recent conference paper drafted by international economics icons Kenneth Rogoff and Maurice Obstfeld who suggest that the financial and economic crisis that is currently making its presence felt across the global economy, at least in part, has something to do with the notion of global current account imbalances. Now, and in all modesty, this is something I have argued extensively at this space and in this way I welcome the likes of Messieurs Rogoff and Obstfeld in the fold. I tend to go, of course, for the big prize in my stubborn persistence on the link between global ageing, global imbalances and thus by way of deduction the economic crisis as we have come to know it.

Now, I am not going to treat this link here but merely point to the rather obvious question at this point in time, in the form of whether in fact the crisis itself has been a catalyst of re-balancing? At a first glance this would clearly seem to be the case. In a crisis driven decisively by a violent process of deleveraging, those economies who had hitherto relied on borrowing have now been forced to scale back (and essentially correct either through a debasement of their currency, internal price correction, or a combination of these two) and the nations that had delivered the funding have likewise been forced to accept that their external surpluses have shrunk in a comparative manner.

So far so good then, but what happens when we have to get the patient out of intensive ward; who will run the deficits and surpluses and what size will the imbalances, if any, be. This is a difficult question to answer, but it appears that with the US economy now being effectively forced to correct its external imbalance (be it with Europe, China, Japan et al kicking and screaming or not), we have a situation with a lot of would be exporters and very little importers.

If this is the general set piece, it was with some interest that I read this VOX.eu piece by Mr. Richard Baldwin and Ms Daria Taglioni which dryly submits the thesis that although it may appear that rebalancing is occurring, this is only as a byproduct of the crisis. From ther horse's own mouth;

Global imbalances are shrinking at a fabulous rate. This column argues that these improvements are mostly illusory – the transitory side-effect of the greatest trade collapse the world has ever seen. A global recovery will almost surely return the US, Germany, China and others to their old paths.

Not exactly the prospect we were all hoping for, but in the main I agree with this point except of course the small and important qualifier that the US economy will have to deleverage and reduce the external (and indeed internal) borrowing. Whether Germany, Japan, China will also need to export ... well, this is ultimately a question of finding a customer.

Rebalancing the Baltics?

The obvious question to arise at this point is obviously what all this has to do with the Baltics? Well, in a direct sense not a whole lot since as the Economist so famously put it, the Baltics remain piqsqueaks and whether we observe current account positions, of either negative or positive pedigree, at some 20% of GDP it won't do much to affect the global imbalances. However, in the light of the idea of rebalancing on the back of the economic crisis and whether this is sustainable let alone feasible, the Baltics become very interesting not least since they have chosen (or have been led into) a process of rebalancing through internal price deflation (devaluation) as their currencies, for now, remain fixed to the Euro. In that vein, I thought it interesting to have a look at how the Baltics have faired so far with a specific focus on the external balance.

Beginning however with a general view of the correction so far the picture is definitely one of a hard landing on the back of the economic crisis.

Most of the readers of this space will be well acquainted with travails of the Baltic economies (and in particular, the near collapse observed in Latvia earlier this year). In all three Baltic economies the Euro value of their GDP peaked in 2007-08 and has since fallen back dramatically. Compared with the average quarterly value of GDP in 2007-08, the first two quarters of 2009 are down in nominal terms to the tune of 15.9%, 15.4% and 10.5% in Lithuania, Estonia, and Latvia respectively. The Baltic economies have lost bn. 2.2 Euros worth of GDP in 2009 from the GDP output observed in 2007-08 which amounts to a loss of some 21% of the average value of the quarterly GDP output for all Baltic economies combined from 1999 to 2009. In short; these economies have taken some blow to the kidneys and even if we can safely say that the levels of nominal GDP observed in 2007-08 were unsustainable the way down is still rough, very rough.

On the price front the correction has indeed begun and the graph above actually underestimates the current bout of price deflation as it smoothes away, as it were, the fact all three Baltic economies are in deflation on a m-o-m basis. Only Estonia registers deflation on my representation with Latvia basically hovering at the 0% line and Lithuania still producing inflation rates at some 2%.

Moving on to the external balance it is worthwhile splitting up the analysis by having a look at first the import/exports picture and then grinding down to the income level and finish off with a look at the financial accounts and thus the inflows used to finance the deficit (or how the surplus is invested abroad).

This is perhaps the best picture of the Baltic correction there is and nicely illustrates the point emphasised by Baldwin and Taglioni that the correction of imbalances, at this point in time, has been very much forced upon the deficit economies. Consider consequently the average quarterly current account deficit of the Baltics from Q3 2008 to Q2 2009 at mill 500 Euros; i.e. at the point when the crisis made its mark decisively.This amount to just 18% (!) of the average quarterly current account deficit two years prior to the crisis. This means that the Baltics have delevered to the tune of 80% relative to the level of the current account deficit observed up to the crisis. Again and with the benefit of hindsight, we know that these levels were unsustainable, but please do remember that it was only back in the H02 2008 that we were discussion whether the Baltics were going to have a hard or a soft landing. It is remarkable to note the example of Latvia here which has gone from a current account deficit of -17.6% of GDP in the period 2007-08 to a current account surplus of 14% of GDP (mill 681.3 Euros) in Q2 2009 due mainly to the fact that imports and GDP have plunged.

This point in particular is important to emphasize since the extent to which we are able to talk to about a sustainable (or benign if you will) process of rebalancing rather than one entirely driven by a sharp correction in internal demand and thus imports. The intuition tells us that Baltics are currently subject to the latter form of rebalancing and thus it remains to be seen whether there is a virtuous circle of increasing competitiveness and rising export shares (and values) on the back of the current vicious circle. But just how vicious is the current circle then?

The graph to the right attempts to answer this question as it plots the equally weighted average of the evolution of exports and imports in the Baltics. The time series corresponds to the value of exports and imports in million of Euros of the three Baltic economies and is indexed with the average quarterly value between Q1-1999 and Q2-2009 of imports and exports as 100.

The graph easily shows how imports have contracted much more than exports and it is consequently here that we must look for the driver of rebalancing in the Baltics. If we take Q1-2006 to Q4-2008 as the peak of the boom (in terms of the external deficits), exports are down 10.8% in the first half of 2009 whereas imports are down a full 33.4% in the same period. This suggests that more than anything that rebalancing in the Baltics are currently driven by a sharp contraction of domestic demand. Splitting up the result on the three economies and looking exclusively at the second quarter of 2009, imports have contracted 16%, 33% and 11.5% more than exports in Lithuania, Latvia and Estonia respectively.

Another way to look at this is to approach the external deficit from the financing side and consequently have a look at the inflows used to finance the external deficits. In principle, you would normally and in the perfect world mainly look at portfolio and investment flows, but in the case of the Baltics we cannot neglect credit flows which, through all those Euro denominated loans supplied by Scandinavian banks, have been instrumental in driving the external deficits during the peak of the boom. If we begin with the inflows as a share of GDP we observe the drastic way in which the financing have been withdrawn in the context of the crisis.

Observe in particular the Latvian situation where an external surplus has been forced upon the economy, proxied here by "negative" inflows and thus outflows. In Lithuania, the total sum of important inflows had declined, as a share of GDP, to 60% in Q2-2009 relative to value recorded during the peak of the boom (Q1-2006 to Q4-2008). The corresponding figure for Estonia is 23% whereas for Estonia it has changed signs all together due to the fact that financing here has come to a complete standstill. In Euro terms, the Baltics have lost external financing to the tune of bn 1.87 Euros in the first half of 2009 compared to the peak of the boom which amounts to 12.6% of the entire region's GDP in the same period.

As noted extensively above, this process is natural since we can say with some confidence that whatever the level (and flow) of incoming investment and credit during the peak years it was not sustainable. However, when it happens with such force in the context of the global financial crisis and, moreover, in relation to fixed exchange regimes and thus internal devaluation the obvious question that begs is what the risk is of pushing these economies into a hole from which they cannot emerge. One particularly important point here is what kind of general (and domestic!) credit and financing environment we will see as the external funding is ground down and thus, in some sense, what kind of domestic environment the Baltics will have to stage a recovery in.

This last point is perhaps the most important underlying theme to think about when assessing the situation in the Baltics. We could almost say that the extent and pace to which the Baltics' growth path has crumbled is also the extent to which expectations of convergence, Euro membership, underlying growth potential etc have crumbled. Where we go from here is consequently anybody's guess. A lot of unresolved question still clouds the horizon not least the continuing unravelling in Latvia where the IMF has so stuck with the country despite the increasing dire outlook as long as the currency peg remains. What I can tell you however is that the Baltics are going to rebalance, but the key is the extent to which it happens so as to allow the Baltic economies to enter a virtuous circle somewhere down the road.

So far, a preliminary assessment suggests that while the Baltics are indeed rebalancing, they are only doing so because internal demand has caved in. We are yet to see whether the dose of internal devaluation/deflation will bring back competitiveness in due time to turn a vicious cycle into a virtuous one.

Just How Much Of A Eurozone Rebound Really Was There In Q3?

by Edward Hugh: Barcelona

Sorry, and I apologise in advance: in this post I'm going to be a nit-picker. The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories. So maybe I should have titled the post "all about inventories", following Pedro Almodovar's cinematographic lead in cycling and recycling that old "all about Eve" metaphor - necessity is the mother of invention, and movements in inventories are progenitors of both growth, and of that notorious double dip difficulty. So just which one of these is it that we have on our hands here?

Indeed, the fact that the devil, as always, lies in the details should not really surprise us since economics isn't that different from other sciences, and isn't such a difficult subject to work with - even if some journalists and lot of bank analysts are able to make it look like it is by managing so frequently to make a dogs dinner out of what should really been an ever so plain, ordinary, and simple vanilla-flavoured ice cream. Let me explain.

Before getting bogged down in all that horrid detail let's register a very simple plain, evident, and totally undisputed item of fact - the "eurozone sixteen" economy (whatever that rather nebulous concept actually refers to, when you dig down a little below the surface) poked its nose timidly out of recession in the third quarter of this year, with gross domestic product in the 16 countries using the euro rising 0.4 percent from the previous quarter (see chart below). This return to positive headline growth technically brings a recession which lasted five consecutive quarters of shrinking output to a close - even though output was still four percent below that registered in the same period in 2008. So evidently we are out of recession, but are we out of the woods yet?



Well, basically I think we aren't, and to explain why I think we aren't I'm going to pick (yet one more time) on poor old Frank Atkins of the Financial Times. It almost hurts me to do this, since I am not trying to say that Frank is an especially bad example of economic journalism (far from it), even if he is sometimes very badly served by his headline writers, writers who over the weekend managed to switch what was Friday's declamatory "Germany powers eurozone recovery" version (and for those who like twitter here) to Sunday's much more modest "European recession ends with a whimper" one. However since this is now the second time in just over as many months that Frank has wheeled out the German economy "powering" something or other word out, I cannot help concluding that either he really likes the expression, or that he must know something I don't about what is actually going on in Germany, since structurally speaking it would seem to me that such "powering" is now completely impossible, given the economy's evident export dependence.

Thus far from powering up anything, the German economy is always - in some significant and non-trivial sense - going to be "powered" by someone or somewhere else. The thing about Frank is - in Eurozone economic terms at any rate - he is both geographically very close to where the action is (ie in Frankfurt), and communicationally very much in touch with thinking in Brussels and Frankfurt, which is what always makes what he has to say interesting, at the very least. On the other hand, since the journalistic consensus seems to have shifted over the weekend - quite literally from a bang to a whimper - we might really want to ask ourselves the tricky question of whether we still think the rebound is as strong as it was first made out to be.

"Germany’s economy expanded by 0.7 per cent in the third quarter", Frank told us (in Friday's version) "marking a sharp acceleration in the pace of recovery in Europe’s largest economy, but the pick-up in France fell short of expectations."

Well, here we have two facts - the Germany economy did grow by 0.7%, and growth in the French economy was below consensus expectations - and one opinion, that the growth represented a sharp acceleration in the German recovery. In fact, in France output expanded by 0.3% in the third quarter, a very similar pace to that seen in the second quarter, but significantly below consensus expectations which were for a 0.6% growth rate.

But really the issue this raises isn't actually one about the French economy at all, but about how the economists in question managed to talk themselves into having such ludicrous expectations, and about what methodology exactly it was they were using to arrive at them. Certainly I am a leading "bull" on the French economy, but I never came anywhere near the quoted number in my estimations, and indeed in my most recent full analysis of the French economy, published 27 October last on A Fistful Of Euros and elsewhere, I actually said this:

"French GDP surprised positively with a 0.3% quarterly gain in the second quarter. Given the data we are seeing, a forecast of 0.2% quarterly growth for both the third and final quarters would not seem to be an unreasonable expectation at this point, which would mean the French economy would shrink by something under 2.5% in 2009, well below the average Eurozone contraction rate."

So you could say, rather than being disappointed I should have been rather surprised on the upside by the outcome, since growth at 0.3% came in higher than my expectation (0.2%). But truth be told, I really wouldn't want to make this claim very strongly, since I was in fact practicing what we Catalans call the ancient art of "trampa" (astute trickery), sin being intentionally excessively prudent in order to outperform, and also trying to shift attention away from the short term headline number issues about this quarters French GDP number to the longer term issue of what happens to monetary policy in a "Eurozone 16" if France recovers significantly more sharply than everyone else.

Before continuing further, I would also make a second point, one which I think is pretty relevant to the whole debate about where the Eurozone actually stands in the here and now, and that is that my most recent piece was actually written about the OCTOBER PMI data, that is I was already looking ahead and talking about prospects for the fourth quarter, whereas Friday's release was actually backward looking, and taking us back in time, in order to revisit not Brideshead, but economic data from the third quarter in an attempt to get a better picture of what was happening back then, even if, as we are now about to see, since Friday's release was only a "flash" one, we still lack most of the detailed breakdown which would enable us to do just that. So in many ways Friday's news was already history (which makes it even more surprising how consensus interpretations have shifted over the weekend) and what really interests us is what is happening now, and where the current so called "recovery" is actually heading. And just to rub our noses right in it, we could remember that a week on Monday (23 November) we will have the Markit Flash PMIs for November (and this will already give us two thirds of the fourth quarter data to play around with, which should help us come up with quite realistic estimates of what eventual GDP will look like).

Thus, despite my openly professed French "bullishness" I do want to stress that I am only expecting modest growth again from France in the fourth quarter, but the important point we should expect this growth to be sustained going forward, and it is this that makes France so different from much of the rest of the Eurozone, since France has the capacity to generate autonomous (endogenously driven) growth in consumer demand and it is precisely this feature that makes the French economy so special (in the Eurozone context) at this point. Anyone looking for dramatic (sustained) surges in the any of the advanced economies at this point is, basically, living on another planet (possibly, I suspect, the one we are all being expected to send our exports to).

Now, after so much palaver, why do I consider this digging for details to be so important? Well, lets look at this from the German Federal Statistics Office:

"In a quarter-on-quarter comparison, when adjusted for price, seasonal and calendar variations, especially exports as well as capital formation in machinery and equipment and in construction had a positive impact on growth. However, a large quarter-on-quarter increase was also recorded for imports which, among other things, led to a build-up in inventories. Final consumptionexpenditure of households, however, was down and slowed down economic growth."

Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don't have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports (largely to stock up on export oriented inventories, not items destined towards domestic consumption) and this part we more or less know, since we do have all the trade data in for the quarter.



So we need to see the magnitude of the German inventory shift, and then we can get an idea of how much this could unwind in Q4. The current position reminds me very much of Q1 2008, when Germany put in a record annualised growth rate (1.7% q-o-q, 7.2% annually) only then to slouch off into recession and four consecutive quarters of GDP contraction. One reason for this surge in GDP, then, was that the huge growth registered was a by product of a massive inventory pile-up (see chart), a pile up which was precisely the result of an anticipated continuation in demand, demand which, as it happened, never materialised.



Now the current position is not as bad as Q1 2008, since the size of the distortion is not so great, and the general external environment may be more supportive in Q4 2009, but still I think the general structural point holds. Indeed the October PMI suggests inventories are coming down again, with Markit reporting that "companies remained cautious regarding input buying and stock levels" and that the "October data showed that both inventories of purchases and finished goods fell sharply over the month". Finally, we should not let this last point from the German Federal Statistics Office Report escape our notice, since at the end of the day it holds the key:

"Final consumption expenditure of households, however, was down and slowed down economic growth."

So now, by way of comparison, let's turn our attention to France, and see what was actually happening there. Now, according to the quarterly report from analysts at Nomura:

"France is the only country to publish a components breakdown and the details are disappointing, with domestic private demand still very depressed. Most of the growth came from public spending and net trade; private consumption was flat, while fixed investment from firms and even more from households retrenched heavily. Inventories continued to decline."


Well, as Nomura say, France has published a table showing the breakdown, and just for the record, here it is:



Now the Nomura people say "with domestic private demand still very depressed", but, I'm sorry, if you take a look at line three in the table, which shows quarter on quarter household consumption, you will see this is stable, and up. In fact France has not shown one single quarter of quarter over quarter contraction in household spending during the whole crisis. This is what I mean when I say robust. Now you could say that this is all about cash for clunkers, and to some extent you would be right, but other countries have had cash for clunkers programmes, and domestic consumption hasn't held up anything like as well, so the outstanding issue for economic theory, and for eurozone monetary and fiscal policy, is why, why does the French economy and none other exhibit this profile?

Now you might want to argue that French household consumption was stationary in the third quarter (and this is what many of the analysts point to), but I would respond by pointing out it is still well up on consumption in the third quarter of 2008 due to the earlier quarters of growth. OK, so we don't exactly have a consumption boom (yet), but is anyone really expecting one at this point? Even in Norway? All I am saying, and saying almost boorishly, to the point that it irritates, is that French consumption has the potential to rise in the coming quarters, while German consumption doesn't, and this is going to be the key FACT about the Eurozone in the months and quarters ahead. And if you find economic at times a boring and tedious subject, then I'm sorry, sometime things are just like that.

And please, please, note this: "Inventories continued to decline."

Look at the next to last line in the table. French inventories fell by 1.5% quarter over quarter. So, to put things plainly, the real difference between those headline GDP numbers for Germany and France is that Germany increased inventories while France ran them down, and government spending in both cases played a large part in the growth. The thing is, in the fourth quarter it is quite likely that Germany will have to run down some of those inventories, while France may start to increase them. Either way, I repeat, at this point French growth (even if at a tortoise pace) looks a lot more robust and a lot more sustainable than growth in any other Eurozone country, and if things turn out as they appear to be, then we will one more time need to be asking ourselves just what it is that is wrong with "convergence theory", since whatever the actual reason behind the present Eurozone divergences, the plain fact of the matter is that they exist.


Conclusions

Basically if we go back to the weekend version of Frank Atkins article, the real powerhouses of the rebound are not France, but, and would you believe it, Germany AND Italy.

"Powering the rebound were Germany and Italy, which saw GDP rising by 0.7 per cent and 0.6 per cent respectively. France’s recovery, however, proved much weaker than expected, with an increase of just 0.3 per cent, the same as in the previous quarter."

Now Germany I can swallow, there is a real issue there about just how far forward Germany can leap, but Italy? I ask you. Let's have a look at Italy's long term growth chart:



My estimation is that Italy's long term trend growth at this point is not far from zero, and indeed it is quite possible that Italy could have its third consecutive year of negative growth in 2010. Italy's growth problems are well know, structural, and long term, and have little to do with the current crisis, so any argument about Italy powering anything very significant at this point, is bound to be skating on thin ice. And then, of course there is Spain, which isn't getting too much mention, but which is consistently likely to pull the Eurozone 16 aggregate growth number down going forward. FT Alphaville's Tracy Alloway draws attention to a summary of the situation from JP Morgan economist David Mackie which seems pretty much to the point.

"The third quarter GDP data suggest that the region has exited recession, but the move was hardly a decisive one. Despite a 12% annualised rate gain in industrial production across the region, GDP managed to increase by only 1.5% annualised rate. Clearly, there was a lot of weakness in construction and services. These data will reinforce the perceptions of the consensus: that the upswing will be lackluster and bumpy. And, they present a major challenge to our more upbeat forecast of growth over the coming year. Indeed, if GDP can only increase by 1.5% annualised rate when IP grows at a double digit pace, the largest gain since 1984, one can only worry about the future."

And as Tracy points out a number of Eurozone economies are still stuck in recession. Spain and Greece we know about, while Ireland, Slovenia and Finland have yet to report. Even the Slovak case is not entirely clear, since we have no seasonally adjusted data.

So, going back to my original question, is this a whimper recovery, or are we on the verge of a double dip? I think, basically, it is all down to Germany, and those inventories. If external demand weakens in key customer countries then Germany will fall back into negative growth, and with it the whole "eurozone sixteen economy". Since demand in the South and the East of Europe is hardly going to be strong, given the new found need of countries in those regions to run trade surpluses, my inkling is that just this outcome is now a clear possibilty. So while the consensus at the moment seems to be that France disappoints, my view is that it is the German economy we really should be worrying about.